Many CPA firm clients are looking to sell their companies and move on to another phase of their lives. Whether they wish to ease out of their company over a period of years or move on quickly, they want to maintain their financial comfort and may also want to ensure that the vision they had for the company when they established ownership would continue. The following article is based primarily on telephone interviews with and materials provided by Richard Thompson, CPA. The article presents Mr. Thompson’s thoughts on the advantages that S corporation companies have over C corporations in ensuring that owners benefit from the sale, and on some factors owners should consider when contemplating a sale.Electing S corporation status is something all owners of C corporations should consider, particularly if they’d like to transfer ownership of their business in the future, says Richard Thompson, CPA, of Sikich  LLP (http://www.sikich.com/). He explains, “If you sell your business, chances are you want to have the most amount of money possible in your pocket after the sale is completed, which makes the S corporation model most appropriate for small business owners.”

Electing S corporation status is something all owners of C corporations should consider, particularly if they’d like to transfer ownership of their business in the future, says Richard Thompson, CPA, of Sikich  LLP (http://www.sikich.com/). He explains, “If you sell your business, chances are you want to have the most amount of money possible in your pocket after the sale is completed, which makes the S corporation model most appropriate for small business owners.”

The general and business media remind us continually how demographics predict many businesses will be sold as owners retire. However, even those for whom a sale of their business seems to be a long-term prospect need to be looking ahead and planning for their time to sell. Thompson says it is important to understand the impact that organizational form has on any potential exit strategy, including the sale of a business.

Thompson believes that the time is favorable for selling a company because prospective buyers, having in recent years held tightly to corporate purse strings, are now untying them. Consider too that 90% of successful companies are acquired before becoming public companies. His opinion is supported by a recent study of cash management conducted by Hackett-REL, Atlanta, a consulting company, and reported by CFO.com (“Cash Scorecard: Unleash the Hoards?” by David Katz, October 17, 2006). Further support comes from Federal Reserve Board Governor Kevin Warsh, who in a speech before the American Enterprise Institute in July cited the following trends in the past few quarters of falling cash-to-assets and cash-to-investment ratios, along with an increasing debt-to-asset ratio in the first quarter of 2006. Warsh attributes the changes to growth in shareholder buybacks, dividend offerings, business spending, and corporate acquisitiveness. Warsh said further that “it appears that firms are likely to continue to draw down their cash balances from the elevated levels witnessed during the past few years.”

Regardless of the market, the S corporation election can provide owners with advantages. Depending on many facts, owners of S corporations can retain more after-tax cash from a sale than owners whose companies are organized as C corporations. The differences between S corporations and C corporations are more pronounced when a business is sold, as was demonstrated in a study cited by Thompson. In a paper describing the study, “The Effect of Organizational Form on Acquisition Price,” Merle Erickson, an associate professor at the University of Chicago Graduate School of Business, and Shiing-wu Wang of the University of Southern California’s Leventhal School of Accounting, demonstrated that S corporations sell for a higher purchase price than C corporations. They reached this conclusion by comparing 77 matched pairs of taxable stock acquisitions of S corporations and C corporations from 1994 to 2000. The sample companies were privately held. The authors estimate that the tax benefits in S corporation acquisitions can total approximately 12% to 17% of the deal’s value, a benefit that shareholders can capture in the form of a higher purchase price.

Sale timing

S corporation status has been the choice of many companies, especially closely held companies, as demonstrated by their growth in number over the years. (See the sidebar on p. 3.) The tax advantages had been a great selling point for this status. At the point of sale, tax advantages continue. In the event of a company’s sale of assets and liquidation, the S corporation status results in substantial savings. A corporation that has always had an S election in place can avoid any federal tax on the sale of its assets.  A corporation that converts from C to S corporation status can be subject to a tax on the sale of its assets to the extent of the appreciation of its assets as of the date of the S election (the “Built-in Gains Tax”) if the sale takes place within ten years of making the S election.  If the asset sale occurs more than ten years after S election, the corporation avoids double tax on all appreciation of assets.

It is important to note, however, that  if the sale occurs within ten years of S corporation election, the seller still avoids double tax on the appreciation of assets since the date of the S election.

In addition, Section 338(h)(10) election allows for a sale of stock to be treated as a sale of assets. This factor can substantially increase the value of an S corporation and increase the likelihood of closing a sale. This election allows a buyer to step up the basis of the assets, thereby benefiting from additional depreciation and amortization and improving the after-tax return on the acquisition. The selling shareholders usually pay only a single level of tax, typically capital gains at the shareholder level.

The built-in gains tax applies to any sale of assets held on the date of the S corporation election if the sale occurs within ten years of the S corporation election. Built-in gain is equal to the excess of the fair market value of an S corporation’s assets on the date of the S election over its tax basis in those assets. In general, built-in gains can be minimized by having the business valued as of the date of the S election.

For an S corporation, built-in gains would probably include the value of

• Goodwill, going concern value

• Technological know-how, patents

• Customer lists

• Cash basis items of income

Tax savings can result from the sale of stock in an S corporation because the shareholder basis in the stock is increased by undistributed taxable income. This increase in basis reduces taxable gain upon sale.

Planning considerations

Whether planning to elect S corporation status or to sell an S corporation, owners need to consider several factors. S corporation shareholders who are considering a company sale as their exit strategy need to consider the many other issues associated with such a sale in addition to the benefits and caveats discussed above. Thompson says that one of the first things to do is have the business valued. In setting the price, the seller needs to consider the arrangement for transition. Any portion of exit transaction consideration that results in immediate deductions for the  buyer generally results in current ordinary income for the seller. For example, the buyer’s deduction for compensation or consulting payments to the seller becomes ordinary income for the seller and is subject to applicable payroll taxes. However, allocation of the exit transaction consideration to assets that create  deferred tax deductions for the buyer can result in capital gains or ordinary income for the seller. For example, a seller will benefit from  capital gain to the extent the purchase price is allocated to goodwill while the buyer will benefit from the ordinary deductions for amortization of that goodwill.  Sellers need to be cautious, however, because the allocation of the purchase price that creates ordinary deductions for the buyer can result in ordinary income for the seller.  For example, an allocation of price that creates depreciation recapture on the sale of fixed assets or the payment of non-compete payments will generate ordinary deductions for the buyer but will result in ordinary income tax for the seller.

Thompson advises the seller to prepare for the sale by enhancing the value of the company. Securing the value of the company should be ongoing, of course. Sometimes, however, owners are unaware of acts or events that can diminish the company’s value. He cited, for example, a restaurant’s being unaware that a competitor was copying its menu and recipes, thereby possibly eroding the restaurant’s market share and its value.

When putting the company on the market, owners need to “clean up” in general, not only by ensuring that facilities are in tip-top shape, but also by ensuring, for example, that accounting systems and procedures are up to date and  effective; intellectual property is properly protected; employment contracts are appropriate; and a management succession plan is in place.

For the company that would benefit from S corporation election, Thompson advises that, to minimize built-in-gains tax, a valuation needs to be done as of the end of the year before making an S election.   Thompson also suggests trying to make the election during “low tide,” a time when profits are lower to help ensure the lowest possible built-in gain.

S does not stand for “simple”

The preceding provides a very broad overview of the issues associated with S corporation elections. It is intended primarily to alert readers to the advantages that S corporations can have in certain situations. Sellers and buyers, of course, need to investigate the many facts and issues associated with allocations, installment sales, state and local tax considerations, and many other issues that impact a sale transaction. Clearly, S corporation election can have  not only tax advantages for shareholders as they operate the company, but also, if timed properly, substantial tax advantages upon sale.